British Pound Nearing Record

The dollar has weakened against several major currencies over the past week. One of the most important currencies the dollar has depreciated against is the British pound ($XBP). The US dollar - pound exchange rate is now approaching $2. Using technical analysis, is there any basis to conclude that the current high values will continue to move higher?

First, it is important to establish whether the value the pound is approaching, $2, is a resistance level. To do this, remember the basic rule: Look left. What I have done is to extend as far back as far as my subscription allows (to the late 1980s). When going this far back, it is necessary to use monthly data so the graph doesn't get very messy.

When doing this, first, clear off the moving averages that are on the StockCharts.com graphs (the 50 and 200 period). Experiment with values and find a period that fits the most recent upsurge very well. In the present context, the 48-month moving average does this, as the graph shows (click to enlarge).

Examination of the graph shows that $2/pound is a very long-term resistance level that dates all the way back to the early 1990s. So, I have drawn a horizontal line to designate this fact. Support is the 48-month Moving Average.

Is it likely that the pound will break above its long-term resistance? The answer is yes, in the near-term, though. Note that the RSI is not yet at or above the overbought reading of 70 yet, so this indicates there is more upside possible. Also, below the main graph I have added a graph that shows how far the actual values of the pound are from the 48-month Moving Average. Apparently, 20 is the resistance level for that divergence (note: this is 20 cents). At present, the divergence graph below is not yet at 20, so this also appears to confirm that there might be further upside for the pound.

Remember, this is a likely outcome, not guaranteed. And, if the pound does move beyond its long-term resistance at $2, it will become overbought fairly quickly thereafter, as the RSI is very close to 70. So, whether a move above $2 can be sustained after it occurs is open to question.

As I have stated in earlier posts, use economics to determine whether the move after $2 (if it does occur is up or down). To do this, you must essentially formulate a forecast of the pound. A key factor is US monetary policy. Also, will the European Central Bank raise rates for the Euro zone? If so, relative US interest rates will fall (as the Fed is on hold with rates for now), causing the pound to appreciate further. See if you can identify other factors that will determine likely future values of the pound.

Employment Report Implications

Today, the September employment report was released. There was a weaker-than-expected employment change of 51,000. If the market's focus were solely on this number, interest rates would have fallen (lower inflation expectations due to slower expected growth), and the stock market should have risen as this is consistent with the "soft landing" scenario.

As it turned out, the stock market dropped slightly. But, the biggest story was that the 10-year bond rose by 9 basis points, all the way up to 4.70%! How did that happen?

First, the bond market, which subscribes to the "hard landing" scenario, had not only priced in that the Fed is finished raising interest rates, they apparently also presumed that the Fed would begin easing early in 2007. Wow! While the 51,000 payroll change would normally have made them happy, there was a sizeable upward revision to August's payroll number (+60,000), the unemployment rate dropped to 4.6%, tied for its lowest value in a while, and the government released a statement indicating that payroll employment gains have been understated through March of this year, by about 800,000.

So, taken together, this information says the economy has more strength than the bond market had presumed, and the likelihood of the Fed lowering interest rates early next year is now remote. What is the outcome? You guessed it, a bond sell off, pushing interest rates higher. Go to StockCharts.com and plot the 10-year bond ($TNX) to see that action for yourself. The chart shows the 10-year (click to enlarge).

Note the large bar for today. Using the Raff Regression Tool (sixth icon from the top right), I made the blue price channel and have indicated three resistance levels (think of these as R1, R2, and R3 as technicans would). I have also located support.

The other story is the recent strength in the dollar. I discussed in class today that when we see the combination of rising stock prices, rising bond prices (declining r) and a rising dollar, this indicates that foreign investors are bringing money into US asset markets. This happened earlier in the week. What about today?

With the threat of a nuclear weapons test by North Korea, the dollar strengthened. Once upon a time (translation: when I was a student), gold was the "safe haven" when indicents like this occurred. Today, gold only rose $1.50. The US dollar has now become the safe haven. And when the US dollar strengthens, US asset markets also become relatively more attractive to foreign investors. This bodes well for stock indices not falling too far too fast. When the US dollar strengthens, this also puts downward pressure on commodity prices. Check out the CRB Index ($CRB) to see this.

Finally, to see the international fallout (sorry!) from the possible nuclear weapons test, check out the Japanese Yen index ($XJY). Not a pretty sight!

Interest Rates and Exchange Rates

Looking at the actual relationship between interest rates and the dollar exchange rate over the last ten years, it is evident from the chart that these have been inversely related for much of the time period (contrary to what theory indicates). This is a good example of how EMPIRICAL relationships such as this can differ from the THEORETICAL relationship. Why is this true? The chart is only looking at these two variables. Other factors relevant to the exchange rate are also changing over this time period. Note, however, that these variables are not perfectly synchronized. This is readily apparent with the most recent bottom in interest rates, which occurred before the recent dollar bottom (and it is not clear at the present time whether this bottom will actually hold).